Optimal Execution Strategies in Limit Order Books with General Shape Functions
29 Pages Posted: 20 Nov 2009
Date Written: November 20, 2009
We consider optimal execution strategies for block market orders placed in a limit order book (LOB). We build on the resilience model proposed by Obizhaeva and Wang (2005) but allow for a general shape of the LOB defined via a given density function. Thus, we can allow for empirically observed LOB shapes and obtain a nonlinear price impact of market orders. We distinguish two possibilities for modeling the resilience of the LOB after a large market order: the exponential recovery of the number of limit orders, i.e., of the volume of the LOB, or the exponential recovery of the bid-ask spread. We consider both of these resilience modes and, in each case, derive explicit optimal execution strategies in discrete time. Applying our results to a block-shaped LOB, we obtain a new closed-form representation for the optimal strategy of a risk-neutral investor, which explicitly solves the recursive scheme given in Obizhaeva and Wang (2005). We also provide some evidence for the robustness of optimal strategies with respect to the choice of the shape function and the resilience type.
Keywords: Liquidity risk, optimal portfolio liquidation, block trade execution, limit order book, market impact model, nonlinear price impact, order book resilience, market order
JEL Classification: G12, G32
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